Finance 3113 Chapter 7

Deferred Call Provision

A call provision prohibiting the company from redeeming a bond prior to a certain date

Identify different terminology that can be used to describe the yield-to-maturity

"market rate" "opportunity cost" "discount rate" "required return"

Identify different terminology that can be used to describe the maturity value

"par value" "face value" "principal" "future value"

Identify different terminology that can be used to describe the coupon rate

"stated rate" "contract rate"

What is the Fisher equation and what are the variable in the equation?

(1 + R) = (1 + r) (1 + h) Where, R = nominal rate, r = real rate, h = expected inflation rate

Zero Coupon Bond

A bond that makes no coupon payments and is thus initially priced at a deep discount

Call-Protected Bond

A bond that, during a certain period, cannot be redeemed by the issuer

What is the relationship between the price of a bond and the yield-to-maturity?

A bond's market price depends on its yield to maturity (YTM). When a bond has a YTM greater than its coupon rate, it sells at a discount from its face value. When the YTM is equal to the coupon rate, the market price equals the face value

Bond

A contract between two parties: one is the investor (you) and the other is a company or a government agency (like a municipal bond). It's normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan

Coupon Bond

A credit market instrument that pays the owner a fixed interest payment every year until the maturity date. when a specified final amount is repaid

Protective Covenant

A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest

Treasury Yield Curve

A plot of the yields on Treasury notes and bonds relative to maturity

Inflation

A rise in prices and a decrease in the value of money

What is the relationship between interest rate risk and the term to maturity?

All other things being equal, the longer the time to maturity, the greater the interest rate risk

What is the relationship between interest rate risk and the coupon rate?

All other things being equal, the lower the coupon rate, the greater the interest rate risk

Put Bonds

Allows the holder to force the issuer to buy back the bond at a stated price

Sinking Fund

An account managed by the bond trustee for early bond redemption

Call Provision

An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity

Debenture

An unsecured debt, usually with a maturity of 10 years or more

Note

An unsecured debt, usually with a maturity under 10 years

Current Yield

Bond's annual coupon interest divided divided by purchase price; measure of a bond's return

What are investment grade bonds?

Bonds rated at least BBB by S&P or Baa by Moody's.

What are junk bonds?

Bonds that fall below the rating of BBB and have a high level of risk and reward.

Convertible Bonds

Bonds that permit bondholders to convert them into common stock at anytime before maturity at the bondholders' option

Floating Rate Bonds (Floaters)

Coupon payments are adjustable. The adjustments are tied to an interest rate index. The market sets these rates daily through trading the securities

If the coupon rate is greater than the market rate, the bond will sell at a ____________.

Discount

Real Rates

Interest rates or rates of return that have been adjusted for inflation

Nominal Rates

Interest rates or rates of return that have not been adjusted for inflation

Sukuk

Islamic bond which by Islamic law cannot charge interest

What kind of risks can represented by the risk premium?

Longer-term bonds have much greater risk of loss resulting from changes in interest rates than do shorter-term bonds. Investors recognize this risk, and they demand extra compensation in the form of higher rates for bearing it. The longer is the term to maturity, the greater is the interest rate risk, so the interest rate risk premium increases with maturity. However, as we discussed earlier, interest rate risk increases at a decreasing rate, so the interest rate risk premium does as well.

What is the difference between a municipal bond and a corporate bond?

Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities, which use the money to build schools, highways, hospitals, sewer systems, and many other projects for the public good. When you purchase a municipal bond, you are lending money to a state or local government entity, which in turn promises to pay you a specified amount of interest (usually paid semiannually) and return the principal to you on a specific maturity date. A corporate bond is a debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company's physical assets may be used as collateral for bonds.

How is interest expense calculated on a zero coupon bond?

No interest payments are made on the bond, zero coupon bond calculations use semiannual periods to be consistent with coupon bond calculations. Interest is not paid until bond maturity. For tax purposes, the issuer of a zero coupon bond deducts interest every year even though no interest is actually paid. Similarly, the owner must pay taxes on interest accrued every year, even though no interest is actually received.

If the coupon rate is equal to the market rate, the bond will sell at ____________.

Par value

What is the effect on the price of a bond and the variables if a bond pays interest annually or semiannually?

Payment frequency mainly affects interest compounding. The more frequent a bond pays its coupon payments, the higher the effective yield of the bond under the same annual coupon rate. If a bond pays coupon interest semiannually instead of annually, it will compound interest twice rather than once, increasing total bond returns at the end of a year. Part of the bond return is also a reflection of the price paid at purchase. Depending on market interest rates, bond prices can be lower or higher as a result of payment frequencies.

If the coupon rate is less than the market rate, the bond will sell at a ____________.

Premium

Yield to Maturity (YTM)

Rate required in the market on a bond

Catastrophe Bonds

Risk linked securities that transfer a specified set of risks from a sponsor to investors

Coupon

Stated interest payment made on a bond

Call Premium

The amount by which the call price exceeds the par value of a bond

Coupon Rate

The annual coupon divided by the face value of a bond

Interest Rate Risk Premium

The compensation investors demand for bearing interest rate risk

Bond ratings measure what kind of risk?

The creditworthiness of the corporate issuer, based on how likely the firm is to default and the protection creditors have in the event of a default. Bond ratings are concerned only with the possibility of default

Bid-Ask Spread

The difference between the bid price and the asked price

Bearer Form

The form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond

Registered Form

The form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record

Accrued Interest

The interest on a bond or loan that has accumulated since the principal investment, or since the previous coupon payment if there has been one already

The real rate of interest represents what?

The percentage change in how much you can buy with your dollars, in other words, the percentage change in your buying power.

Liquidity Premium

The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity

Default Risk Premium

The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default

Taxability Premium

The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status

Inflation Premium

The portion of a nominal interest rate that represents compensation for expected future inflation

Bid Price

The price a dealer is willing to pay for a security

Asked Price

The price a dealer is willing to take for a security

Dirty Price

The price of a bond including accrued interest, also known as the full or invoice price. this is the price the buyer actually pays

Clean Price

The price of a bond net of accrued interest; this is the price that is typically quoted

Face Value (Also called Par Value)

The principal amount of a bond that is repaid at the end of the term

Term Structure of Interest Rates

The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money

Fisher Effect

The relationship between nominal returns, real returns, and inflation

Interest rate risk

The risk that arises for bond owners from fluctuating interest rates

Maturity

The specified date on which the principal amount of a bond is paid

Indenture

The written agreement between the corporation and the lender detailing the terms of the debt issue

Identify and explain briefly the theories of the term structure of interest rates?

Upward sloping: When long-term rates are higher than short-term rates. Downward sloping: When short-term rates are higher Humped: When rates increase at first, but then begin to decline as we look at longer- and longer-term rates.

How are Treasury Bond prices quoted or reported?

With a Series EE bond, you pay a particular amount today of, say, $25, and the bond accrues interest over the time you hold it. In early 2014, the U.S. Treasury promised to pay .10 percent per year on EE savings bonds. In an interesting (and important) wrinkle, if you hold the bond for 20 years, the Treasury promises to "step up" the value to double your cost. That is, if the $25 bond you purchased and all the accumulated interest earned are worth less than $50, the Treasury will automatically increase the value of the bond to $50.

What is the price of a bond and what are the variables in determining the price of a bond?

You need to know the number of periods remaining until maturity (N), the face value, the coupon, and the market interest rate (YTM)

Reverse Convertible

a relatively new type of structured note. One type generally offers a high coupon rate, but the redemption at maturity can be paid in cash at par value or paid in shares of stock.

Term Structure Of Interest Rates

the relationship between time to maturity and yields, all else equal. More precisely, it tells us what nominal interest rates are on default-free, pure discount bonds of all maturities.